**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT  TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934.**                                                                                                                                            |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                          |
| ** ** | ** ** | **For the quarterly period  ended March 31, 2005.**                                                                                                                                                                                            |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                          |
| **OR**     |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                          |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934.**                                                                                                                                          |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                          |
| ** ** | ** ** | **For the  transition period from                   to                 ** |

** **

**CommissionFile Number: 1-11388**

** **

**PLC SYSTEMS INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 
| **Yukon  Territory, Canada**                | ** ** | **04-3153858**                        |
|---------------------------------------------|------------|---------------------------------------|
| (State or  Other Jurisdiction of            |       | (I.R.S.  Employer Identification No.) |
| Incorporation  or Organization)             |       |                                  |
|                                        |       |                                  |
| **10 Forge  Park, Franklin, Massachusetts** | ** ** | **02038**                             |
| (Address of  Principal Executive Offices)   |       | (Zip Code)                            |

 

Registrant’s telephone number,including area code: **(508) 541-8800**

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. **Yes ****ý****   No****o**

 

Indicate by check mark whether the registrant is an accelerated filer (asdefined in Rule 12b-2 of the Exchange Act)  **Yes ****o****   No****ý**

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 
| **Class**                   | ** ** | **Outstanding at May 9, 2005** |
|-----------------------------|------------|-------------------------------------|
| Common  Stock, no par value |       | 30,067,686                          |

 

 

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**PLCSYSTEMS INC.**

 

**Index**

 
| Part I.  | Financial Information: |                                                                                        |
|---------------|------------------------|---------------------------------------------------------------------------------------------|
|          |                   |                                                                                        |   |
|          | Item 1.                | Financial Statements                                                                        |   |
|          |                   |                                                                                        |   |
|          |                   | Condensed Consolidated Balance Sheets  (unaudited)                                          |   |
|          |                   |                                                                                        |   |
|          |                   | Condensed Consolidated Statements of  Operations (unaudited)                                |   |
|          |                   |                                                                                        |   |
|          |                   | Condensed Consolidated Statements of Cash  Flows (unaudited)                                |   |
|          |                   |                                                                                        |   |
|          |                   | Notes to Condensed Consolidated Financial  Statements (unaudited)                           |   |
|          |                   |                                                                                        |   |
|          | Item 2.                | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|          |                   |                                                                                        |   |
|          | Item 3.                | Quantitative and Qualitative Disclosures  about Market Risk                                 |   |
|          |                   |                                                                                        |   |
|          | Item 4.                | Controls and Procedures                                                                     |   |
|          |                   |                                                                                        |   |
| Part II. | Other Information:     |                                                                                        |
|          |                   |                                                                                        |   |
|          | Item 6.                | Exhibits                                                                                    |   |

 

2

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**PLCSYSTEMS INC.**

**Part I.****                          FinancialInformation**

 

**Item 1.****           FinancialStatements**

 

**PLCSYSTEMS INC.**

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                                                                           | ** ** | **March 31,  2005** | ** ** | **December 31,   2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                           | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Current assets:                                                                                                                                      |       |                     |       |                         |       |
| Cash and cash equivalents                                                                                                                            |       | $                        | 2,599      |                         | $          | 9,678 |   |
| Short-term investments                                                                                                                               |       | 6,900                    |       | —                       |       |
| Accounts receivable – Edwards                                                                                                                   |       | 1,232                    |       | 1,144                        |       |
| Accounts receivable – other, net of  allowance of $84 and $104 in 2005 and 2004, respectively                                                   |       | 200                      |       | 261                          |       |
| Inventories, net                                                                                                                                     |       | 1,279                    |       | 1,112                        |       |
| Prepaid expenses and other current assets                                                                                                            |       | 778                      |       | 592                          |       |
| Total current assets                                                                                                                                 |       | 12,988                   |       | 12,787                       |       |
|                                                                                                                                                 |       |                     |       |                         |       |
| Equipment, furniture and leasehold  improvements, net                                                                                                |       | 296                      |       | 293                          |       |
| Other assets                                                                                                                                         |       | 241                      |       | 247                          |       |
| Total assets                                                                                                                                         |       | $                        | 13,525     |                         | $          | 13,327 |   |
|                                                                                                                                                 |       |                     |       |                         |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                        | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Current liabilities:                                                                                                                                 |       |                     |       |                         |       |
| Accounts payable                                                                                                                                     |       | $                        | 402        |                         | $          | 328 |   |
| Accrued compensation                                                                                                                                 |       | 466                      |       | 430                          |       |
| Accrued other                                                                                                                                        |       | 304                      |       | 301                          |       |
| Deferred revenue – Edwards                                                                                                                      |       | 1,263                    |       | 999                          |       |
| Deferred revenue – other                                                                                                                        |       | 65                       |       | 71                           |       |
| Total current liabilities                                                                                                                            |       | 2,500                    |       | 2,129                        |       |
|                                                                                                                                                 |       |                     |       |                         |       |
| Deferred revenue – Edwards                                                                                                                      |       | 4,206                    |       | 4,181                        |       |
| Deferred revenue – other                                                                                                                        |       | 188                      |       | 188                          |       |
| Total long-term liabilities                                                                                                                          |       | 4,394                    |       | 4,369                        |       |
|                                                                                                                                                 |       |                     |       |                         |       |
| Commitments and contingencies                                                                                                                        |       |                     |       |                         |       |
|                                                                                                                                                 |       |                     |       |                         |       |
| Stockholders’ equity:                                                                                                                           |       |                     |       |                         |       |
| Preferred stock, no par value, unlimited  shares authorized, none issued and outstanding                                                             |       |                     |       |                         |       |
| Common stock, no par value, unlimited  shares authorized, 30,068 shares issued and outstanding as of March 31,  2005 and December 31, 2004 |       | 93,731                   |       | 93,731                       |       |
| Accumulated deficit                                                                                                                                  |       | (86,766                  | )          | (86,582                      | )          |
| Accumulated other comprehensive loss                                                                                                                 |       | (334                     | )          | (320                         | )          |
| Total stockholders’ equity                                                                                                                      |       | 6,631                    |       | 6,829                        |       |
| Total liabilities and stockholders’ equity                                                                                                      |       | $                        | 13,525     |                         | $          | 13,327 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

3

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**PLCSYSTEMS INC.**

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per sharedata)

(Unaudited)

 
| ** **                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Revenues:                           |       |                                   |       |   |   |
| Product sales – Edwards        |       | $                                      | 1,408      |   | $ | 1,362 |   |
| Product sales – other          |       | 150                                    |       | 169 |   |
| Service fees – Edwards         |       | 311                                    |       | 353 |   |
| Service fees – other           |       | 74                                     |       | 25 |   |
| Total revenues                      |       | 1,943                                  |       | 1,909 |   |
|                                |       |                                   |       |   |   |
| Cost of revenues:                   |       |                                   |       |   |   |
| Product sales – Edwards        |       | 485                                    |       | 534 |   |
| Product sales – other          |       | 67                                     |       | 56 |   |
| Service fees – Edwards         |       | 138                                    |       | 147 |   |
| Service fees – other           |       | 38                                     |       | 29 |   |
| Total cost of revenues              |       | 728                                    |       | 766 |   |
|                                |       |                                   |       |   |   |
| Gross profit                        |       | 1,215                                  |       | 1,143 |   |
|                                |       |                                   |       |   |   |
| Operating expenses:                 |       |                                   |       |   |   |
| Selling, general and administrative |       | 880                                    |       | 990 |   |
| Research and development            |       | 571                                    |       | 529 |   |
| Total operating expenses            |       | 1,451                                  |       | 1,519 |   |
| Loss from operations                |       | (236                                   | )          | (376 | ) |
| Other income, net                   |       | 52                                     |       | 26 |   |
| Net loss                            |       | $                                      | (184       | ) | $ | (350 | ) |
|                                |       |                                   |       |   |   |
| Basic and diluted loss per share    |       | $                                      | (0.01      | ) | $ | (0.01 | ) |
| Average shares outstanding:         |       |                                   |       |   |   |
| Basic                               |       | 30,068                                 |       | 29,924 |   |
| Diluted                             |       | 30,068                                 |       | 29,924 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

4

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**PLCSYSTEMS INC.**

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Operating activities:                                                                       |       |                                   |       |   |   |
| Net loss                                                                                    |       | $                                      | (184       | ) | $ | (350 | ) |
|                                                                                        |       |                                   |       |   |   |
| Adjustments to reconcile net loss to net  cash provided by (used for) operating activities: |       |                                   |       |   |   |
| Depreciation and amortization                                                               |       | 33                                     |       | 21 |   |
|                                                                                        |       |                                   |       |   |   |
| Change in assets and liabilities:                                                           |       |                                   |       |   |   |
| Accounts receivable – Edwards                                                          |       | (89                                    | )          | (87 | ) |
| Accounts receivable – other                                                            |       | 68                                     |       | (57 | ) |
| Inventories                                                                                 |       | (168                                   | )          | 49 |   |
| Prepaid expenses and other assets                                                           |       | (185                                   | )          | (195 | ) |
| Accounts payable                                                                            |       | 74                                     |       | 349 |   |
| Deferred revenue – Edwards                                                             |       | 289                                    |       | 4,765 |   |
| Deferred revenue – other                                                               |       | (3                                     | )          | 45 |   |
| Accrued liabilities                                                                         |       | 39                                     |       | (61 | ) |
| Net cash provided by (used for) operating  activities                                       |       | (126                                   | )          | 4,479 |   |
|                                                                                        |       |                                   |       |   |   |
| Investing activities:                                                                       |       |                                   |       |   |   |
| Purchase of short-term investments                                                          |       | (6,900                                 | )          | — |   |
| Purchase of equipment                                                                       |       | (30                                    | )          | (53 | ) |
| Net cash used for investing activities                                                      |       | (6,930                                 | )          | (53 | ) |
|                                                                                        |       |                                   |       |   |   |
| Financing activities:                                                                       |       |                                   |       |   |   |
| Net proceeds from sales of common shares                                                    |       | —                                 |       | 86 |   |
| Net cash provided by financing activities                                                   |       | —                                 |       | 86 |   |
|                                                                                        |       |                                   |       |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                               |       | (23                                    | )          | (9 | ) |
| Net increase (decrease) in cash and cash  equivalents                                       |       | (7,079                                 | )          | 4,503 |   |
|                                                                                        |       |                                   |       |   |   |
| Cash and cash equivalents at beginning of  period                                           |       | 9,678                                  |       | 6,377 |   |
| Cash and cash equivalents at end of period                                                  |       | $                                      | 2,599      |   | $ | 10,880 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

5

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**PLCSYSTEMS INC.**

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2005

 

***1.******                                     ******Natureof Business***

 

PLC Systems Inc. (“PLC” or the “Company”) is a medical device companyspecializing in innovative technologies for the cardiac and vascularmarkets.  The Company currentlymanufactures lasers for use in the treatment of cardiovascular disease.  PLC pioneered the *CO2Heart Laser System* (“The Heart Laser System”) that cardiac surgeonsuse to perform carbon dioxide (CO2) transmyocardialrevascularization (“TMR”) to alleviate symptoms of severe angina.  In addition, PLC is completing thedevelopment of and manufacturing the Optiwave 980 cardiac laser ablation system(“Optiwave 980 System”) under an agreement with Edwards Lifesciences LLC (“Edwards”).  Following commercial release, the Optiwave980 System is expected to be utilized by surgeons to ablate cardiac tissue as ameans to treat certain heart arrhythmias.

 

Edwards is the Company’s exclusive worldwide distributor for allsurgical cardiac ablation products and, in the United States, acts as the Company’sexclusive distributor for TMR products. Edwards is also the Company’s largestshareholder, owning approximately 18% of its outstanding common stock as of March 31,2005, and has a representative on the Board of Directors.

 

***2.******                                     ******Basis of Presentation***

 

The accompanying unaudited condensedconsolidated financial statements of the Company have been prepared inaccordance with generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10of Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring adjustments) considered necessary for a fairpresentation have been included. Operating results for the three months ended March 31, 2005 are notnecessarily indicative of the results that may be expected for the year ending December 31,2005.  These financial statements shouldbe read in conjunction with the consolidated financial statements and footnotesthereto included in the Company’s annual report on Form 10-K for theyear ended December 31, 2004. Certain prior year amounts have been reclassified to conform to thecurrent year’s presentation.

 

***3.******                                      EdwardsTransaction***

 

In February 2004, the Company signed an agreement with Edwards toassume development of the Optiwave 980 System. Under the terms of the agreement, the Company will have exclusivemanufacturing rights to build the Optiwave 980 System and other relatedsurgical products. The Company will be responsible, among other things, forongoing research and development and manufacture of the product and forobtaining regulatory approvals.  Edwardswill be responsible for the approval, funding and conduct of any clinicalstudies designed to obtain data in support of a new product approval orclearance as required by the FDA or other regulatory body.

 

6

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In conjunction with signing this new agreement, the terms of theCompany’s TMR distribution agreement with Edwards were modified to (1) extendthe term of the agreement until at least October 17, 2017 and (2) reducethe Company’s share of revenue on TMR kits sold to hospitals. The Companyreceived as consideration from Edwards, a lump-sum payment of $4,533,333, whichwas recorded as deferred revenue in the Company’s Consolidated BalanceSheet.  See Note 8, “Revenue Recognition”.

 

***4.******                                      Lossper Share***

 

For the three months ended March 31, 2005 and 2004, basic anddiluted loss per share have been computed using only the weighted averagenumber of common shares outstanding during the period without giving effect toany potential future issues of common stock related to stock option programsand warrants since their inclusion would be antidilutive.

 

For the three months ended March 31,2005 and 2004, 5,168,422 and 5,307,422 shares, respectively, attributable tooutstanding stock options and warrants were excluded from the calculation ofdiluted earnings (loss) per share because the effect was antidilutive.  The following table sets forth thecomputation of basic and diluted earnings (loss) per share:

 
| ** **                                           | ** ** | **Three Months Ended March 31,**     | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(In thousands, except per share data)** | ** ** |
|                                                 |       |                                      |       |
| Net loss available for common shareholders           |       | $                                         | (184       | ) | $ | (350 | ) |
| Weighted average outstanding shares of  common stock |       | 30,068                                    |       | 29,924 |   |
| Dilutive effect of employee stock options            |       | —                                    |       | — |   |
| Common stock and common stock equivalents            |       | 30,068                                    |       | 29,924 |   |
| Loss per share:                                      |       |                                      |       |   |   |
| Basic                                                |       | $                                         | (0.01      | ) | $ | (0.01 | ) |
| Diluted                                              |       | $                                         | (0.01      | ) | $ | (0.01 | ) |

 

***5.******                                      Stock-BasedCompensation***

 

The Company grants stock options for a fixed numberof shares to employees and certain other individuals with exercise prices equalto the fair value of the shares at the dates of grant. The Company has adoptedthe disclosure-only provisions of Statement of Financial Accounting Standards No. 123,*Accounting for Stock-based Compensation*(“SFAS 123”), as amended, and presently accounts for its stock option plans inaccordance with the provisions of Accounting Principles Board Opinion 25, *Accounting for Stock Issued to Employees*(“APB 25”).

 

The following tableillustrates the effect on net loss and basic loss per share if the Company hadapplied the fair value recognition provisions of SFAS 123 to stock-basedemployee compensation:

 

7

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| ** **                                                                                                          | ** ** | **Three Months Ended March 31,**     | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                                                                                          | ** ** | **(In thousands, except per share data)** | ** ** |
| Net loss attributable to common  stockholders—  As reported                                                    |       | $                                         | (184       | ) | $ | (350 | ) |
| Deduct total stock-based compensation  expense determined under fair value based method for all stock option awards |       | (34                                       | )          | (32 | ) |
| Net loss attributable to common  stockholders—  Pro forma                                                      |       | (218                                      | )          | (382 | ) |
| Loss per basic and diluted share  attributable to common stockholders—   As reported                           |       | $                                         | (0.01      | ) | $ | (0.01 | ) |
| Loss per basic and diluted share  attributable to common stockholders—   Pro forma                             |       | $                                         | (0.01      | ) | $ | (0.01 | ) |

 

The fair value of issued options at the date of grant was estimatedusing the Black-Scholes model with the following weighted average assumptions:

 
| ** **              | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------|------------|----------------------------------------|------------|
| ** **              | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Expected life (years)   |       | N/A                                    |       | 3 |   |
| Interest rate           |       | N/A                                    |       | 1.47 | % |
| Volatility              |       | N/A                                    |       | .803 |   |
| Expected dividend yield |       | N/A                                    |       | None |   |

 

The Company did not grant any stock optionsduring the quarter ended March 31, 2005. Therefore, there were no assumptions of expected life, interest rate,volatility or expected dividend yield.

 

***Recent Accounting Pronouncement***

 

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004), *Share-Based Payments* (“SFAS 123R”), which is a revision ofSFAS No. 123. SFAS 123R supersedes APB 25. SFAS 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values. Thedisclosure only approach permitted by SFAS 123 and elected by the Company, isno longer an alternative. Accordingly, the adoption of SFAS 123R’s fair valuemethod may have a significant impact on the results of operations, although itwill have no impact on the Company’s overall financial position. The impact ofadoption of SFAS 123R cannot be predicted at this time because it will dependon levels of share-based payments granted in the future. However, had theCompany adopted SFAS 123R, the impact of that standard would have approximatedthe impact of SFAS 123 as described in the disclosure of pro forma net incomeand earnings per share above.

 

8

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***6.******                                      ComprehensiveLoss***

 

Total comprehensive loss for the three-month period ended March 31,2005 and March 31, 2004 amounted to $198,000 and $353,000,respectively.  Comprehensive loss iscomprised of net loss plus the increase/decrease in currency translationadjustment.

 

***7.******                                      Inventories***

 

Inventories are stated at the lower of cost ormarket using the first-in, first-out (FIFO) method and consist of the following(in thousands):

 
| ** **       | ** ** | **March 31,  2005** | ** ** | **December 31,   2004** | ** ** |
|------------------|------------|--------------------------|------------|------------------------------|------------|
| Raw materials    |       | $                        | 1,115      |                         | $          | 889 |   |
| Work in progress |       | 62                       |       | 130                          |       |
| Finished goods   |       | 102                      |       | 93                           |       |
|             |       | $                        | 1,279      |                         | $          | 1,112 |   |

 

At March 31, 2005 and December 31, 2004,inventories are stated net of a reserve of $512,000 and $528,000, respectively,for potentially obsolete inventory.

 

***8.******                                      RevenueRecognition***

 

The Company records revenue from the sale of TMR kits and Optiwave 980Systems at the time of shipment to Edwards. TMR kit revenues include the amount invoiced to Edwards for kits shippedpursuant to purchase orders received, as well as an amortized portion ofdeferred revenue related to Edwards’ payment of $4,533,333 in February 2004.  This payment was made by Edwards in exchangefor a reduction in the prospective purchase price the Company receives fromEdwards upon a sale of the kits (see Note 3). The Company is amortizing this payment from Edwards into itsConsolidated Statement of Operations as revenue over a seven year period underthe units-of-revenue method as prescribed by Emerging Issues Task Force (EITF)88-18, *Sales of Future Revenue*.  Management determined that a seven yeartimeframe was the most appropriate amortization period based on a valuationmodel they used to assess the economic fairness of the payment. Factors managementconsidered in developing this valuation model included the estimated foregonerevenues over a seven year period resulting from the reduction in theprospective purchase price payable to the Company by Edwards, a discount ratedeemed appropriate to the transaction and an estimate of the remaining economicuseful life of the current TMR kit design, without any benefit being given topotential future product improvements the Company may make. For the threemonths ended March 31, 2005, the Company has recorded amortization of$76,000.

 

TMR lasers are billed to Edwards in accordance with purchase ordersthat the Company receives. Invoiced TMR lasers are recorded as other currentassets and deferred revenue on the Company’s Consolidated Balance Sheet untilsuch time as the laser is shipped to a hospital, at which time the Companyrecords revenue and cost of revenue.

 

9

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Under the terms of the Edwards TMR distribution agreement, once Edwardshas recovered a prescribed amount of revenue from a hospital for the use orpurchase of a TMR laser, any additional revenues earned by Edwards are sharedwith the Company pursuant to a formula established in the distributionagreement. The Company only records its share of such additional revenue, ifany, at the time the revenue is earned.

 

The Company recordsrevenue from the sale of TMR kits and TMR lasers to international distributorsor hospitals at the time of shipment.

 

Revenues from service and maintenance contracts arerecognized ratably over the life of the contract.

 

Installation revenues related to a TMR lasertransaction are recorded as a component of service fees when the laser isinstalled.

 

# ***9.****                                     **Warranty and PreventativeMaintenance Costs*

# ** **

The Company warranties its products against manufacturing defects undernormal use and service during the warranty period.  The Company obtains similar warranties from amajority of its suppliers, including those who supply critical Heart LaserSystem components.  In addition, underthe terms of our TMR distribution agreement with Edwards, the Company is ableto bill Edwards for actual warranty costs, including preventative maintenanceservices, up to a specified amount during the warranty period.

 

The Company evaluates the estimated future unrecoverable costs ofwarranty and preventative maintenance services for its installed base of laserson a quarterly basis and adjusts its warranty reserve accordingly.  The Company considers all available evidence,including historical experience and information obtained from supplier audits.

 

Changes in the warranty accrual were as follows (in thousands):

 
| ** **                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Balance, beginning of period                               |       | $                                      | 60         |   | $ | 60 |   |
| Payments made                                              |       | —                                 |       | — |   |
| Change in liability for warranties issued  during the year |       | —                                 |       | 7 |   |
| Change in liability for preexisting  warranties            |       | —                                 |       | (7 | ) |
|                                                       |       |                                   |       |   |   |
| Balance, end of period                                     |       | $                                      | 60         |   | $ | 60 |   |

 

**Item 2.****                       Management’sDiscussion and****Analysis of FinancialCondition and Results of Operations**

 

This quarterly report (including certain information incorporatedherein by reference) contains forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”). Statementscontaining terms such as “believes”, “plans”, “expects”, “anticipates”, “intends”,“estimates” and similar expressions reflect uncertainty and are forward-

 

10

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looking statements.Forward-looking statements are based on current plans and expectations andinvolve known and unknown important risks and uncertainties that could causeactual results to differ materially from those described in the forward-lookingstatements. Such important factors and uncertainties include, but are notlimited to, those set forth below under the heading “Certain Factors that May Affectour Future Results” and elsewhere in this quarterly report.

 

# **Overview**

# ** **

We are a medical device company specializing in innovative technologiesfor the cardiac and vascular markets.  Wecurrently manufacture lasers for use in the treatment of cardiovasculardisease.  Our Heart Laser Systems areused to treat patients with severe angina and the Optiwave 980 System, whencommercially introduced, is expected to be used to ablate cardiac tissue as ameans to treat certain heart arrhythmias.

 

Edwards is our exclusive worldwide distributor for all surgical cardiacablation products and, in the United States, acts as our exclusive distributorfor TMR products. Edwards is our largest customer, accounting for approximately88% of our total sales for both the three months ended March 31, 2005 andthe year ended December 31, 2004. We expect this sales trend to continuefor the foreseeable future.

 

Approximately 87% and 90% of our revenues in the three months ended March 31,2005 and the year ended December 31, 2004, respectively, came from thesale and service of TMR lasers and related disposable kits. Although not adirect measure, we believe a leading indicator of the adoption rate of TMR as atreatment for severe angina is TMR kit shipments to hospitals.  We remain largely dependent on the success ofEdwards’ sales and marketing efforts to increase our installed base of TMRlasers and increase TMR procedure volumes and revenues.

 

Our management reviews a number of key performance indicators to assistthem in determining how to allocate resources and run our day to dayoperations. These indicators include (1) actual prior quarterly salestrends, (2) projected TMR laser and kit sales for the next four quarters,as provided by Edwards in a rolling twelve month sales forecast, (3) researchand development progress as measured against internal project plan objectives, (4) budgetto actual financial expenditure results, (5) inventory levels (both ourown and Edwards’) and (6) short term and long term projected cash flows ofthe business.

 

**Application of Critical Accounting Policiesand Estimates**

 

This management’s discussion and analysis of financial condition andresults of operations is based on our condensed consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. Our significant accounting policies are more fully described in Note 2of the Notes to Consolidated Financial Statements as well as in “Item 7 -Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Critical Accounting Policies and Estimates”, each as contained inour Annual Report on Form 10-K for the year ended December 31,2004.  No significant changes were madeto those policies during the three months ended March 31, 2005.

 

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# ***Inventories***

# ** **

Inventories are stated at the lower of cost or market value.  A specific obsolescence allowance is providedfor slow moving, excess and obsolete inventory based on our best estimate ofthe net realizable value of inventory on hand taking into consideration factorssuch as (1) actual trailing twelve month sales, (2) expected futureproduct line demand, based in part on sales forecast input received fromEdwards, and (3) service part stocking levels which, in management’s bestjudgment, are advisable to maintain in order to meet warranty, service contractand time and material spare part demands. Historically, we have found our reserves to be adequate.

 

# ***Allowancefor Doubtful Accounts***

# ** **

For our accounts receivable, we continuously monitor collections fromcustomers, our principal customer being Edwards, and we maintain a provisionfor estimated credit losses based upon historical experience and any specificcustomer collection issues that we have identified.  Historically, we have not experiencedsignificant losses related to our accounts receivable.  Collateral is not generally required. If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.

 

# ***Warrantyand Preventative Maintenance Costs***

# ** **

We warranty our products against manufacturing defects under normal useand service during the warranty period. We obtain similar warranties from a majority of our suppliers, includingthose who supply critical Heart Laser System components.  In addition, under the terms of our TMRdistribution agreement with Edwards, we are able to bill Edwards for actualwarranty costs, including preventative maintenance services, up to a specifiedamount during the warranty period.

 

We evaluate the estimated future unrecoverable costs of warranty andpreventative maintenance services for our installed base of lasers on aquarterly basis and adjust our warranty reserve accordingly.  We consider all available evidence, includinghistorical experience and information obtained from supplier audits.

 

## ***Revenue Recognition***

## ** **

We record revenue from the sale of TMR kits and Optiwave 980 Systems atthe time of shipment to Edwards.  TMR kitrevenues include the amount invoiced to Edwards for kits shipped pursuant to purchaseorders received, as well as an amortized portion of deferred revenue related toEdwards’ payment to us of $4,533,333 in February 2004 in exchange for areduction in the prospective purchase price we receive from Edwards upon a saleof the kits. We are amortizing this payment from Edwards into our ConsolidatedStatement of Operations as revenue over a seven year period under theunits-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18,*Sales of Future Revenue*. We determinedthat a seven year timeframe was the most appropriate amortization period basedon a valuation model we used to assess the economic fairness of the payment.Factors we considered in developing this valuation model included the estimatedforegone revenues over a seven year period resulting from the reduction in theprospective purchase price payable to us by Edwards, a discount rate deemedappropriate to 

 

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the transaction and an estimateof the remaining economic useful life of the current TMR kit design, withoutany benefit being given to potential future product improvements we may make.For the three months ended March 31, 2005, we recorded amortization of$76,000.

 

TMR lasers are billed to Edwards in accordance with purchase ordersthat we receive. Invoiced TMR lasers are recorded as other current assets anddeferred revenue on our consolidated balance sheet until such time as the laseris shipped to a hospital, at which time we record revenue and cost of revenue.

 

Under the terms of the Edwards TMR distribution agreement, once Edwardshas recovered a prescribed amount of revenue from a hospital for the use orpurchase of a TMR laser, any additional revenues earned by Edwards are sharedwith us pursuant to a formula established in the distribution agreement. Weonly record our share of such additional revenue, if any, at the time therevenue is earned.

 

We record revenue from thesale of TMR kits and TMR lasers to international distributors or hospitals atthe time of shipment.

 

Revenues from service and maintenance contracts arerecognized ratably over the life of the contract.

 

Installation revenues related to a TMR lasertransaction are recorded as a component of service fees when the laser isinstalled.

 

**Results of Operations**

 

Results forthe three months ended March 31, 2005 and 2004 and the related percent ofrevenues were as follows:

 
| ** **                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------------|------------|
| ** **                                 | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | **$**                                  | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                 | ** ** | **(dollars in thousands)**             | ** ** |
| Total revenues                             |       | $                                      | 1,943      |   | 100.0 | % | $ | 1,909 |   | 100.0 | % |
| Total cost of sales                        |       | 728                                    |       | 37.5 |   | 766 |   | 40.1 |   |
| Gross profit                               |       | 1,215                                  |       | 62.5 |   | 1,143 |   | 59.9 |   |
| Selling, general & administrative |       | 880                                    |       | 45.3 |   | 990 |   | 51.9 |   |
| Research & development            |       | 571                                    |       | 29.4 |   | 529 |   | 27.7 |   |
| Income (loss) from operations              |       | (236                                   | )          | (12.1 | ) | (376 | ) | (19.7 | ) |
| Other income                               |       | 52                                     |       | 2.7 |   | 26 |   | 1.4 |   |
| Net income (loss)                          |       | $                                      | (184       | ) | (9.5 | )% | $ | (350 | ) | (18.3 | )% |
|                                            |            |                                        |            |  |  |  |  |  |  |  |  |  |

 

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| ** **                                           | ** ** | **Three Months Ended   March 31,** | ** ** | ** ** | ** ** | ** **                          | ** ** |
|------------------------------------------------------|------------|-----------------------------------------|------------|------------|------------|-------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                | ** ** | **2004**   | ** ** | **Increase (decrease)   over 2004** | ** ** |
| ** **                                           | ** ** | **$**                                   | ** ** | **$**      | ** ** | **$**                               | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **(dollars in thousands)**              | ** ** |
| Product sales                                        |       | $                                       | 1,558      |       | $          | 1,531                               |       | $ | 27 |   | 2 | % |
| Service fees                                         |       | 385                                     |       | 378        |       | 7                                   |       | 2 |   |
| Total revenues                                       |       | 1,943                                   |       | 1,909      |       | 34                                  |       | 2 |   |
| Product cost of sales                                |       | 552                                     |       | 590        |       | (38                                 | )          | (6 | ) |
| Service fees cost of sales                           |       | 176                                     |       | 176        |       | —                              |       | — |   |
| Total cost of revenues                               |       | 728                                     |       | 766        |       | (38                                 | )          | (5 | ) |
| Gross profit                                         |       | 1,215                                   |       | 1,143      |       | 72                                  |       | 6 |   |
| Selling, general & administrative  expenses |       | 880                                     |       | 990        |       | (110                                | )          | (11 | ) |
| Research & development expenses             |       | 571                                     |       | 529        |       | 42                                  |       | 8 |   |
| Total operating expenses                             |       | 1,451                                   |       | 1,519      |       | (68                                 | )          | (4 | ) |
| Other income                                         |       | 52                                      |       | 26         |       | 26                                  |       | 100 |   |
| Net income (loss)                                    |       | $                                       | (184       | )          | $          | (350                                | )          | $ | 166 |   | 47 | % |

 

***Product Sales***

 

TMR laser revenues, the largest component of product sales in the threemonths ended March 31, 2005, decreased by $282,000, or 29%, as compared tothe three months ended March 31, 2004. This decrease is primarily attributable to a $297,000, or 30%, decreasein domestic TMR laser revenues generated through our Edwards saleschannel.  The $297,000 decline indomestic TMR laser revenues is primarily a result of a decrease in the numberof new TMR laser units sold by Edwards in the first quarter of 2005 (four)compared to the first quarter of 2004 (six) coupled with decreased revenuesharing earned under the TMR distribution agreement.  These decreases were offset in part by ahigher average domestic selling price on TMR laser sales.

 

Disposable TMR kit revenues, the second largest component of productsales, increased by $177,000, or 40%, in the three months ended March 31,2005 as compared to the three months ended March 31, 2004.  The increase is primarily related to a$155,000, or 41%, increase in domestic disposable revenue.  This $155,000 increase resulted from (1) ahigher volume of kit shipments to Edwards and (2) an increase in deferredrevenue amortization related to the $4,533,333 payment by Edwards.International disposable revenue increased by $22,000, or 39%, due to anincrease in the number of TMR kits shipped to international customers in thethree months ended March 31, 2005 as compared to the three months ended March 31,2004.

 

Optiwave 980 System revenues from Edwards increased $153,000 in thethree months ended March 31, 2005 as compared to the three months ended March 31,2004 when we had no such sales.  TheOptiwave 980 System revenues we have recognized to date consist of laser powersources sold to Edwards for use in marketing evaluations that they areconducting. We do not expect significant revenues from Optiwave 980 Systemsales until such time that Edwards commercially launches the system into the marketand we successfully increase our disposable manufacturing capacity to meetEdwards’ sales demand. We believe it will take us approximately 

 

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six months to sufficientlyincrease our disposable manufacturing capability if and when Edwards providesus with a sales forecast and, therefore, we do not expect at this time togenerate any revenues from the sale of Optiwave disposables in 2005.

 

Other product sales, relating to sales of new and refurbished surgicaltubes, decreased $21,000, or 18%, in the three months ended March 31, 2005as compared to the three months ended March 31, 2004.

 

***Service Fees***

 

Service fees increased $7,000, or 2%, in the three months ended March 31,2005 as compared to the three months ended March 31, 2004.  International service revenues increased$49,000, or 66%, in the three months ended March 31, 2005 as compared tothe three months ended March 31, 2004. This increase was offset in part by a decrease in domestic servicerevenues of $42,000, or 14%, in the three months ended March 31, 2005 ascompared to the three months ended March 31, 2004 due to decreasedbillings to Edwards for installations and other service related calls.

 

***Gross Profit***

 

Total gross profit was $1,215,000, or 63% of total revenues, for thethree months ended March 31, 2005 as compared with gross profit of $1,143,000, or 60% of total revenues, for the three months ended March 31,2004.  The increase in gross profitdollars in the first quarter of 2005 as compared to the first quarter of 2004is due to (1) higher disposable TMR revenues, (2) new product salesof Optiwave 980 Systems, (3) a higher average domestic selling price onTMR laser sales and (4) an increase in service related revenues. Theseincreases were offset in part by (1) a decrease in the number of new TMRlasers sold, (2) a decrease in additional revenue sharing earned under theTMR distribution agreement and (3) a decrease in other product salesrelating to sales of new and refurbished surgical tubes.

 

***Selling, General andAdministrative Expenses***

 

The 11% decrease in selling, general and administrative expenses in thethree months ended March 31, 2005 as compared to the three months ended March 31,2004 is primarily a result of decreased expenditures related to legal andaccounting fees, annual report production, and the provision for baddebts.  These decreases were offset inpart by increased salary and associated fringe benefits, travel and insuranceexpenditures.

 

***Research and Development Expenses***

 

The largest component of our research and development expenses in thethree months ended March 31, 2005 and 2004 was salaries and associatedfringe benefits, which amounted to 40% and 38%, respectively, of expenditures.

 

The increased expenditures in the three months ended March 31,2005 as compared to the three months ended March 31, 2004 were incurred inconnection with the development of the Optiwave 980 System due to increasedsalaries and associated fringe benefits related to this program and additionalproduct development work on longer term research and development projects.

 

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We expect tocontinue to incur significant new research and development expenditures in 2005in pursuit of our business strategy to broaden and diversify our productportfolio.  In particular, we expect ourannual 2005 research and development expenditures to increase in the aggregateapproximately $600,000 compared to 2004 as a result of expected continued workon the Optiwave 980 System and other longer term research and developmentprojects.

 

***Other Income***

 

The largest component of other income is interest income earned on ourcash and short-term investments. Interest income increased $26,000 in the firstquarter of 2005 compared to the first quarter of 2004 due to higher averageinterest earned on our cash and short-term investments.

 

***Net Loss***

 

The decrease in net loss to $184,000 in the first quarter of 2005 ascompared to $350,000 in the first quarter of 2004 resulted primarily fromhigher gross margin dollars generated and lower operating expenses.

 

We expect to incur a net loss in the twelve months ended December 31,2005, primarily as a result of our planned increased investments in researchand development expenses, as discussed above.

 

***Kit Shipments***

 

We view disposable kit shipments to end users as an important metric inevaluating our business.  We believe kitshipments are a reasonable indicator for the adoption of TMR as a therapy inthe marketplace.  Disposable kitshipments to end users during the three months ended March 31, 2005 and March31, 2004 were as follows:

 
| ** **    | ** ** | **March 31,   2005** | ** ** | **% Increase   over 2004** | ** ** | **March 31,   2004** | ** ** |
|---------------|------------|----------------------|------------|----------------------------|------------|----------------------|------------|
|          |       |                 |       |                       |       |                 |       |
| Domestic      |       | 439                  |       | 15                         | %          | 382                  |       |
| International |       | 50                   |       | 11                         |       | 45                   |       |
| Total         |       | 489                  |       | 15                         | %          | 427                  |       |

 

**Liquidity and Capital Resources**

 

At March 31, 2005, we had cash, cash equivalents and short-terminvestments of $9,499,000.  We have nodebt obligations.

 

During the three-month period ended March 31, 2005, we recorded a netloss of $184,000.  The net loss wasoffset by net unfavorable working capital changes which resulted in net cashused for operating activities of approximately $126,000.  Cash used in investing activities wasapproximately $6,930,000, consisting of the purchase of short-term investmentsof $6,900,000 and investments in equipment. We believe that our existing cash resources will meet our workingcapital requirements through the next 12 months.

 

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We are largely dependent on the success of Edwards’ sales and marketingefforts in the U.S. to continue to increase the installed base of HL2 lasersand substantially increase TMR procedural volumes and revenues. Should theinstalled base of HL2 lasers or TMR procedural volume not increasesufficiently, our liquidity and capital resources will be negativelyimpacted.  Additionally, otherunanticipated decreases in operating revenues or increases in expenses orfurther changes or delays in third-party reimbursement to healthcare providersusing our products may adversely impact our cash position and require furthercost reductions or the need to obtain additional financing.  It is not certain that we, working withEdwards and our international distributors, will be successful in achievingbroad commercial acceptance of the Heart Laser Systems, or that we will be ableto operate profitably in the future on a consistent basis, if at all.

 

Some hospital customersprefer to acquire the Heart Laser Systems on a usage basis rather than as acapital equipment purchase.  We believethis is the result of limitations many hospitals currently have on acquiringexpensive capital equipment as well as competitive pressures in themarketplace.  A usage business model willresult in a longer recovery period for Edwards to recoup its investment inlasers it purchases from us.  Thisresults in (1) a delay in our ability to receive additional shared revenue, ifany, that we otherwise are entitled to receive under the terms of ourdistribution agreement with Edwards (see “Critical Accounting Policies andEstimates – Revenue Recognition”) and (2) a delay in the purchase of new lasersby Edwards if its installed base of lasers placed under usage contracts areunder-performing and it chooses to re-deploy these lasers to other hospitalsites in lieu of purchasing a new laser from us.  Our cash position and our need for additionalfinancing to fund operations will be dependent in part upon the number ofhospitals that acquire Heart Laser Systems from Edwards on a usage basis andthe number and frequency of TMR procedures performed by these hospitals.

 

Furthermore, we haverecently undertaken a new business strategy that involves broadening anddiversifying our product portfolio beyond our current TMR offerings, bydeveloping or acquiring new and innovative medical devices to address cardiacand vascular related markets. We believe this strategy will result in ourincurring losses for at least the next 12-24 months as we increase ourinvestments in both manufacturing and research and development staff necessaryto pursue these new strategic initiatives, including, but not limited to, theOptiwave 980 System. We cannot be certain that we will be successful inimplementing our new business strategy or that future sales, if any, from theseplanned new products will recover the investments we plan to make. If we areunsuccessful in implementing our new business strategy, or if thediversification of our product portfolio takes longer or costs more thananticipated, our liquidity and capital resources will be adversely affected andwe may need to obtain additional financing.

 

There can be no assurance that, should we require additional financing,such financing will be available on terms and conditions acceptable to us.  Should additional financing not be availableon terms and conditions acceptable to us, additional actions may be requiredthat could adversely impact our ability to continue to realize assets andsatisfy liabilities in the normal course of business.  The consolidated financial statements setforth in this report do not include any adjustments to reflect the possiblefuture effects of these uncertainties.

 

**Off-Balance Sheet Arrangements**

 

None.

 

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## **CertainFactors that May Affect our Future Results**

 

The risks and uncertainties described below are not the only risks weface.  Additional risks and uncertaintiesnot presently known to us or currently deemed immaterial may also impair ourbusiness operations.  If any of thefollowing risks actually occur, our financial condition and operating resultscould be materially adversely affected.

 

***We expect to incursignificant operating losses in the near future***

 

We incurred a net loss in the quarter ended March 31, 2005.  We expect to continue to incur net losses forat least the next 12-24 months as we increase our spending in the areas ofmanufacturing and research and development for the Optiwave 980 System andother strategic research and development programs. Moreover, as we continue topursue our new business strategy of acquiring or developing new medical devicesto address cardiac and vascular related markets, we may continue to incurexpenses that exceed the revenues we generate. We cannot provide any assurance that we will be successful with our newbusiness strategy or that we will ever return to profitability.

 

***Our company iscurrently dependent on one principal product line to generate revenues***

 

We currently market one product line, which consists of two patentedhigh-powered carbon dioxide lasers and related TMR disposable kits known as theHeart Laser Systems, which account for the majority of our total revenue.  Approximately 87% and 90% of our revenues inthe three months ended March 31, 2005 and the year ended December 31, 2004,respectively, were derived from the sales and service of our Heart Laser Systems.  This absence of a diversified product linemeans that we are directly and materially impacted by changes in the market forHeart Laser Systems.

 

***Our company isdependent on one principal customer***

 

Pursuant to the terms of our TMR distribution agreement with Edwards,Edwards is our exclusive distributor for our HL2 TMR laser and TMR kits in theUnited States.  In addition, pursuant tothe terms of our new distribution agreement with Edwards for the Optiwave 980System (as well as any other additional surgical products that we may developfor the treatment of atrial fibrillation, or AF), Edwards is our exclusiveworldwide distributor of those products. As a result of these exclusive distribution arrangements, Edwardsaccounted for 88% of our total revenues in both the three months ended March 31,2005 and the year ended December 31, 2004 and we expect Edwards to account forthe significant majority of our revenue in the future.  If our relationship with Edwards does notprogress as anticipated, or if Edwards’ sales and marketing strategies fail togenerate sales of our products in the future, our revenue will decreasesignificantly and our business, financial condition and results of operationswill be seriously harmed.

 

***Our company isdependent on certain suppliers***

 

Some of the components forour Heart Laser Systems, most notably the power supply and certain optics andfabricated parts for the HL2, and certain components for the Optiwave 980System, are only available from one supplier, and we have no assurance that wewill be able to source any of our sole-sourced components from additionalsuppliers.  We are dependent upon our 

 

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sole suppliers to perform their obligations in atimely manner.  In the past, we haveexperienced delays in product delivery from our sole suppliers and, because wedo not have an alternative supplier to produce these products for us, we havelittle leverage to enforce timely delivery. Any delay in product delivery orother interruption in supply from these suppliers could prevent us from meetingour commercial demands for our products, which could have a material adverseeffect on our business, financial condition and results of operations.  Furthermore, we do not require significantquantities of any components because we produce a limited number of ourproducts each year.  Our low-quantityneeds may not generate substantial revenue for our suppliers.  Therefore, it may be difficult for us to continueour relationships with our current suppliers or establish relationships withadditional suppliers on commercially reasonable terms, if at all, and suchdifficulties may seriously harm our business, financial condition and resultsof operations.

 

***Edwards mustsuccessfully complete their marketing evaluations of the Optiwave 980 Systembefore they commit to launch the product***

 

Edwards is currently conducting marketingevaluations of the Optiwave 980 System at hospitals across the country. Edwardsmust complete these marketing evaluations and judge them to be successfulbefore they will commit to launch the product into the market. Although webelieve the evaluations of the product to date have been positive, we cannotassure you that Edwards will successfully complete these marketing evaluationsof the Optiwave 980 System or that they will not decide to cancel the programin the future. Should Edwards decide for whatever reason not to market theOptiwave 980 System, our revenue growth prospects, financial condition andresults of operations will be materially and adversely affected.

 

***We must transitionmanufacturing of the Optiwave 980 disposable handpieces from Edwards and beable to manufacture them in required volumes at commercially reasonable costs***

 

AssumingEdwards successfully completes their marketing evaluations of the Optiwave 980System, we must successfully transition production of the Optiwave 980disposable handpieces to our leased manufacturing space in Billerica,Massachusetts.  We must hire new skilledmanufacturing employees and we must develop and validate our manufacturingprocesses with respect to building these disposable handpieces.  We expect to incur expenses to outfit ourmanufacturing space with the necessary production and test equipment and totrain our employees on how to build the product. We will need to be able tomanufacture these highly specialized disposable handpieces for which we have nocomparable prior experience producing at any volume.  Until such time as we become more proficientin these manufacturing methods, if ever, we may encounter problems, includingthose related to:

 

•                  production yields;

•                  quality control;

•                  training;

•                  shortages of qualifiedpersonnel; and

•                  potential capacityconstraints.

 

Suchproblems could severely affect our ability to adequately scale up productionand meet demand for our products on a timely basis, which could harm ourbusiness, financial condition and results of operations.

 

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***We are dependent upon our key personnel andwill need to hire additional key personnel in the near future***

 

Ourability to operate our business successfully depends in significant part uponthe retention and motivation of certain key technical, regulatory, productionand managerial personnel and consultants and our ongoing ability to hire andretain additional qualified personnel in these areas. Competition for suchpersonnel is intense, particularly in the Greater Boston area. We cannot becertain that we will be able to attract such personnel and the loss of any ofour current key employees or consultants could have a significant adverseimpact on our business.

 

***Our company may beunable to raise needed funds***

 

As of March 31, 2005, we had cash, cash equivalents and short-terminvestments totaling $9,499,000.  Basedon our current operating plan, we anticipate that our existing capitalresources should be sufficient to meet our working capital requirements for atleast the next 12 months.  However, ifour business does not progress in accordance with our current business plan, wemay need to raise additional funds in the future.  We may not be able to raise additionalcapital upon satisfactory terms, or at all, and our business, financialcondition and results of operations could be materially and adverselyaffected.  To the extent that we raiseadditional capital by issuing equity or convertible securities, ownershipdilution to our shareholders will result. To the extent that we raise additional capital through the incurrence ofdebt, our activities may be restricted by the repayment obligations and otherrestrictive covenants related to the debt.

 

***In order to competeeffectively, our current and future products need to gain commercial acceptance***

 

TMR and surgical ablation for cardiac arrhythmias are still bothemerging technologies.  Our current andplanned future products may never achieve widespread commercialacceptance.  To be successful, we needto:

 

•                  demonstrateto the medical community in general, and to heart surgeons and cardiologists inparticular, that TMR and surgical tissue ablation for cardiac arrhythmias areprocedures that are effective, relatively safe and cost effective;

 

•                  supportthird-party efforts to document the medical processes by which TMR proceduresrelieve angina and surgical tissue ablation cures cardiac arrhythmias;

 

•                  havemore heart surgeons trained to perform TMR procedures using the Heart LaserSystems and surgical tissue ablation procedures using the Optiwave 980 System;and

 

•                  maintainand expand third-party reimbursement for the TMR procedure.

 

To date, only a limited number of heart surgeons have been trained inthe use of TMR using the Heart Laser Systems and cardiac tissue ablationprocedures using the Optiwave 980 System. We are dependent on Edwards to expand related marketing and trainingefforts in the U.S. for the use of our products.

 

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Although the Heart Laser Systems have received FDA approval and the CEMark, they have not yet received widespread commercial acceptance.  We believe that concerns over the lack of aconsensus view on the reason or reasons why a TMR procedure relieves angina inpatients who undergo the procedure has limited demand for and use of the HeartLaser Systems. Until there is consensus, if ever, of the medical processes bywhich TMR procedures relieve angina, we believe some hospitals may delay theimplementation of a TMR program.

 

In addition, although the Optiwave 980 System has received FDAclearance, it has not yet secured the CE Mark and it is therefore not yet readyfor worldwide commercialization. If we are unable to maintain regulatoryclearances, secure the CE Mark for the Optiwave 980 System or achievewidespread commercial acceptance of the Heart Laser Systems or the Optiwave 980System, our business, financial condition and results of operations will bematerially and adversely affected.

 

***Our competitor inTMR may obtain FDA approval to market a new device, the impact of which isuncertain on the future adoption rate of TMR***

 

Our primary TMR competitor, CardioGenesis, is attempting to obtain FDAapproval to market their “percutaneous” method of performing myocardialrevascularization, previously known as PMR, and recently rebranded as PMC(percutaneous myocardial channeling), which would provide a less invasivemethod of creating channels in the heart.  If PMC can be shown to be safeand effective and is approved by the FDA, it would eliminate the need incertain patients to make an incision in the chest, reducing costs and speedingrecovery.  It is unclear what impact, ifany, an approval of a PMC device would have on the future adoption rate for TMRprocedures.  If PMC is approved, it coulderode the potential TMR market which would have a material adverse effect onour business, financial condition and results of operations.

 

***Rapid technologicalchanges in our industry could make our products obsolete***

 

Our industry is characterized by rapid technological change and intensecompetition.  New technologies andproducts and new industry standards will develop at a rapid pace, which couldmake our current and future planned products obsolete. The advent of newdevices and procedures and advances in new drugs and genetic engineering areespecially concerning competitive threats. Our future success will depend upon our ability to develop and introduceproduct enhancements to address the needs of our customers.  Material delays in introducing productenhancements may cause customers to forego purchases of our products andpurchase those of our competitors.

 

Many potential competitors have substantially greater financialresources and are in a better financial position to exploit marketing andresearch and development opportunities. In addition, we are aware that other companies are developing or alreadyhave developed proprietary systems for the treatment of cardiac arrhythmias,and specifically AF, that may be safer, clinically more effective, easier andmore cost effective to use and, in the case of percutaneous devices, lessinvasive than the system we are developing.

 

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***We must receive andmaintain government clearances or approvals in order to market our products***

 

Our products and our manufacturing activities are subject to extensive,rigorous and changing federal and state regulation in the U.S. and to similarregulatory requirements in other major international markets, including theEuropean Union and Japan.  Theseregulations and regulatory requirements are broad in scope and govern, amongother things:

 

•                  product designand development;

•                  product testing;

•                  productlabeling;

•                  product storage;

•                  premarketclearance and approval;

•                  advertising andpromotion; and

•                  product salesand distribution.

 

Furthermore, regulatory authorities subject a marketed product, itsmanufacturer and the manufacturing facilities to continual review and periodicinspections.  We are subject to ongoingFDA requirements, including required submissions of safety and otherpost-market information and reports, registration requirements, Quality Systemsregulations, and recordkeeping requirements. The FDA’s Quality Systemsregulations include requirements relating to quality control and qualityassurance, as well as the corresponding maintenance of records anddocumentation.  Edwards, our distributor,depending on its activities, is also subject to certain requirements under theFederal Food, Drug, and Cosmetic Act and the regulations promulgatedthereunder, and state laws and registration requirements covering thedistribution of our products.  Regulatoryagencies may change existing requirements or adopt new requirements or policiesthat could affect our regulatory responsibilities or the regulatoryresponsibilities of a distributor like Edwards. We may be slow to adapt or may not be able to adapt to these changes ornew requirements.

 

Later discovery of previously unknown problems with our products,manufacturing processes, or our failure to comply with applicable regulatoryrequirements may result in enforcement actions by the FDA and otherinternational regulatory authorities, including, but not limited to:

 

•                  warning letters;

•                  patient orphysician notification;

•                  restrictions onour products or manufacturing processes;

•                  voluntary ormandatory recalls;

•                  productseizures;

•                  refusal toapprove pending applications or supplements to approved applications that wesubmit;

•                  refusal topermit the import or export of our products;

•                  fines;

•                  injunctions;

•                  suspension orwithdrawal of marketing approvals or clearances; and

•                  civil andcriminal penalties.

 

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Should any of these enforcement actions occur, our business, financialcondition and results of operations could be materially and adversely affected.

 

To date, we have received the following regulatory approvals for ourproducts:

 

***Heart Laser Systems***

 

*United States —*Wereceived FDA approval to market the HL1 Heart Laser System in August 1998 andthe HL2 Heart Laser System in January 2001. However, although we have received FDA approval, the FDA:

 

•                  has restrictedthe use of the Heart Laser Systems by not allowing us to market these productsto treat patients whose condition is amenable to conventional treatments, suchas heart bypass surgery, stenting and angioplasty; and

 

•                  could imposeadditional restrictions or reverse its ruling and prohibit use of the HeartLaser Systems at any time.

 

*Europe —*We receivedthe CE Mark from the European Union for the HL1 and HL2 in March 1995 andFebruary 2001, respectively.  However:

 

•                  the EuropeanUnion could impose additional restrictions or reverse its ruling and prohibituse of the Heart Laser Systems at any time; and

 

•                  France hasprohibited, and other European Union countries could prohibit or restrict, useof the Heart Laser Systems.

 

*Japan —*We cannotmarket our product in Japan until we receive government approval.

 

Prior to marketing the Heart Laser Systems in Japan, we must receiveapproval from the Japanese government. This approval requires a clinical studyin Japan with at least 60 patients.  Astudy was completed in 1998 with the HL1. Although the results of this studyhave been submitted to the Japanese government, we do not know whether theclinical study will be sufficient or when, if ever, we will receive approval tosell the HL1 in Japan. In addition, it is unclear what impact the introductionof the HL2 into the U.S. and other international markets will have on ourability to market the HL1 in Japan.

 

***Optiwave 980 System***

 

*United States —*The FDA has given clearance to the Optiwave 980System through the 510(k) premarket notification process with indications foruse as a surgical instrument for coagulation of soft tissue, including cardiactissue, in conjunction with or without endoscopic equipment in the contact ornon-contact mode in open or closed surgical procedures.

 

Although we have receivedclearance from the FDA only for the indications of use stated above,physicians, under the practice of medicine exception, may use the Optiwave 980System in any manner they choose in treating an individual patient, includingusing the device to treat patients with AF. However, neither we nor Edwards have conducted any clinical trialsdesigned to obtain data to submit to the FDA for the purpose of obtaining aspecific indication for use of the Optiwave 

 

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980 System that would allow us to make claims orotherwise market this device for the treatment of AF. We are aware of at leastone company which has indicated they have submitted data to the FDA in supportof a labeling claim that, if clearance is obtained, would allow them to markettheir device for the treatment of AF.

 

In the event this companyor other competitors are successful in obtaining specific indications of usefor their devices in the treatment of AF, the Optiwave 980 System may be at acompetitive marketing disadvantage until such time, if ever, that Edwardsconducts a clinical trial, submits sufficient data to the FDA by means of a new510(k) and obtains clearance to market the Optiwave 980 System for thetreatment of AF. We cannot provide any assurance that Edwards will ever conductsuch a clinical trial or, if they do, that the data they obtain and submit tothe FDA will be sufficient for the FDA to expand the current indications of useand provide clearance for the Optiwave 980 System to be marketed for thetreatment of AF. Also, we cannot assure you that even if such clearance isobtained, that it will be obtained in a timely enough fashion for our productsto remain competitive in the marketplace.

 

*Europe —*The Optiwave 980 System cannot be marketed in the EUuntil such time as it receives CE Mark approval. We need to complete and submitthe relevant technical documentation to the appropriate certifying body inorder to be able to apply the CE Mark that, if granted, will enable the productto be distributed in the EU.

 

***Changes in third party reimbursement forour TMR procedure could materially affect future demand for our TMR products***

 

Currently, Medicare and Blue Cross Blue Shield provide coverage for TMRwhen it is performed as both a sole therapy treatment and when used as anadjunct to bypass surgery. Certain other private insurance companies and healthmaintenance organizations also currently provide reimbursement for these TMRprocedures performed with our products, and physician reimbursement codes havebeen established for both surgical procedures; however, we have limited data asto the breadth of this coverage for the TMR procedures by private insurancecompanies and health maintenance organizations. Should third party insurancereimbursement for our TMR products be reduced or eliminated in the future, ourbusiness, financial condition and results of operations would be materially andadversely affected.

 

In July 2004, CMS convened the Medicare Coverage Advisory Committee(MCAC) to review and discuss the evidence and clinical data regarding TMR. TheMCAC is an advisory panel consisting of clinicians and other medical expertswhich CMS utilizes to supplement their own internal expertise. Although theMCAC was not convened for the purpose of making a reimbursement coveragerecommendation, we believe CMS has reviewed the information presented at theMCAC meeting and has decided to continue existing Medicare coverage for TMRwithout any modification. No assurance can be given that CMS will not choose toalter Medicare coverage in the future, which could include (1) issuing newguidelines clarifying the patient criteria for Medicare reimbursement, (2)reducing, modifying or eliminating the existing reimbursement coverage for TMRor (3) requesting additional clinical studies to be performed.

 

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*** ***

***Asserting anddefending intellectual property rights may impact our results of operations***

 

In our industry, competitors often assert intellectual propertyinfringement claims against one another. The success of our business depends on our ability to successfullydefend our intellectual property.  Futurelitigation may have a material impact on our financial condition even if we aresuccessful in marketing our products. We may not be successful in defending orasserting our intellectual property rights.

 

An adverse outcome in any litigation or interference proceeding couldsubject us to significant liabilities to third parties and require us to ceaseusing the technology that is at issue or to license the technology from thirdparties.  In addition, a finding that anyof our intellectual property is invalid could allow our competitors to moreeasily and cost-effectively compete with us. Thus, an unfavorable outcome in any patent litigation or interferenceproceeding could have a material adverse effect on our business, financialcondition or results of operations.

 

The cost to us of any patent litigation or interference proceedingcould be substantial.  Uncertaintiesresulting from the initiation and continuation of patent litigation orinterference proceedings could have a material adverse effect on our ability tocompete in the marketplace.  Patentlitigation and interference proceedings may also absorb significant managementtime.

 

***We may be subject toproduct liability lawsuits; our insurance may not be sufficient to coverdamages***

 

We may be subject to product liability claims.  Such claims may absorb significant managementtime and could degrade our reputation and the marketability of ourproducts.  If product liability claimsare made with respect to our products, we may need to recall the implicatedproduct which could have a material adverse effect on our business, financialcondition and results of operations. In addition, although we maintain productliability insurance, we cannot be sure that our insurance will be adequate tocover potential product liability lawsuits. Our insurance is expensive and inthe future may not be available on acceptable terms, if at all. If a successfulproduct liability claim or series of claims exceeds our insurance coverage, itcould have a material adverse effect on our business, financial condition andresults of operations.

 

***We are subject torisks associated with international operations***

 

A portion of our product sales are generated from operations outside ofthe U.S.  Establishing, maintaining andexpanding international sales can be expensive. Managing and overseeing foreign operations are difficult and productsmay not receive market acceptance.  Risksof doing business outside the U.S. include, but are not limited to, thefollowing: agreements may be difficult to enforce and receivables difficult tocollect through a foreign country’s legal system; foreign customers may havelonger payment cycles; foreign countries may impose additional withholdingtaxes or otherwise tax our foreign income, impose tariffs or adopt otherrestrictions on foreign trade; U.S. export licenses may be difficult to obtain;and the protection of intellectual property rights in foreign countries may bemore difficult to enforce.  There can beno assurance that our international business will grow or that any of theforegoing risks will not result in a material adverse effect on our business orresults of operations.

 

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***Because we areincorporated in Canada, you may not be able to enforce judgments against us andour Canadian directors***

 

Under Canadian law, you may not be able to enforce a judgment issued bycourts in the U.S. against us or our Canadian directors. The status of the lawin Canada is unclear as to whether a U.S. citizen can enforce a judgment from aU.S. court in Canada for violations of U.S. securities laws. A separate suitmay need to be brought directly in Canada.

 

***Our stock price hashistorically fluctuated and may continue to fluctuate significantly in thefuture which may result in losses for our investors***

 

Our stock price has been and may continue to be volatile. Some of thefactors that can affect our stock price are:

 

•                  the announcementof new products, services or technological innovations by us or ourcompetitors;

•                  actual oranticipated quarterly increases or decreases in revenue, gross margin orearnings, and changes in our business, operations or prospects;

•                  speculation oractual news announcements in the media or industry trade journals about ourcompany, our products, the TMR or cardiac ablation procedures or changes inreimbursement policies by Medicare and/or private insurance companies;

•                  announcementsrelating to strategic relationships or mergers;

•                  conditions ortrends in the medical device industry;

•                  changes in theeconomic performance or market valuations of other medical device companies;and

•                  general marketconditions or domestic or international macroeconomic and geopolitical factorsunrelated to our performance.

 

***The market price ofour stock may fall if shareholders sell their stock***

 

Certain current shareholders hold large amounts of our stock, whichthey could sell in the public market from time to time.  Sales of a substantial number of shares ofour common stock within a short period of time could cause our stock price to fall.  In addition, the sale of these shares couldimpair our ability to raise capital through the sale of additional stock.

 

***We have no intention to pay dividends***

 

We have never paid any cash dividends on our common stock. We currentlyintend to retain all future earnings, if any, for use in our business and donot expect to pay any dividends in the foreseeable future.

 

**Item3.****        Quantitative and Qualitative Disclosuresabout Market Risk**

 

A portion of our operations consists of salesactivities in foreign jurisdictions.  Wemanufacture our products exclusively in the U.S. and sell our products in theU.S. and abroad. As a result, our financial results could be affected byfactors such as changes in foreign currency exchange rates or weak economicconditions in the foreign markets in which we distribute our products.  Our operating results are exposed to changesin exchange rates between the U.S. dollar and foreign currencies, especiallythe Euro. When the U.S. dollar strengthens against the Euro, the 

 

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value of foreign sales decreases. When the U.S. dollar weakens, thefunctional currency amount of sales increases. No assurance can be given thatforeign currency fluctuations in the future will not adversely affect ourbusiness, financial condition and results of operations, although at present wedo not believe that our exposure is significant as international salesrepresented only 9% and 6% of our consolidated sales in the three months endedMarch 31, 2005 and the year ended December 31, 2004, respectively.  We do not hedge any balance sheet exposuresand intercompany balances against future movements in foreign exchange rates.

 

Our interest income and expense are sensitive to changes in the generallevel of U.S. and foreign interest rates. In this regard, changes in U.S. andforeign interest rates affect the interest earned on our cash and cashequivalents.  We do not believe that a10% change to the applicable interest rates would have a material impact on ourfuture results of operations or cash flows.

 

## **Item 4.**        Controls and Procedures

 

Ourmanagement, with the participation of our chief executive officer and chieffinancial officer, evaluated the effectiveness of our disclosure controls andprocedures as of March 31, 2005.  Theterm “disclosure controls and procedures”, as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act, means controls and other procedures of acompany that are designed to ensure that information required to be disclosedby a company in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.  Disclosurecontrols and procedures include, without limitation, controls and proceduresdesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is accumulated andcommunicated to the company’s management, including its principal executive andprincipal financial officers, as appropriate to allow timely decisionsregarding required disclosure. Management recognizes that any controls and procedures, no matter howwell designed and operated, can provide only reasonable assurance of achievingtheir objectives and management necessarily applies its judgment in evaluatingthe cost-benefit relationship of possible controls and procedures.  Based on the evaluation of our disclosurecontrols and procedures as of March 31, 2005, our chief executive officer andchief financial officer concluded that, as of such date, our disclosurecontrols and procedures were effective at the reasonable assurance level.

 

No change in our internalcontrol over financial reporting occurred during the fiscal quarter ended March31, 2005 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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# **Part II. **Other Information

 

**Item 6.****        Exhibits**

 
| 10.1   |   | Amendment dated March 15, 2005 to Terms of Employment between PLC  Medical Systems, Inc. and Dr. Robert I. Rudko, incorporated by reference to  the Registrant’s current report on Form 8-K filed with the Securities and  Exchange Commission on March 17, 2005. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                   |
| 31.1   |   | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)  or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                  |
|   |   |                                                                                                                                                                                                                                                                   |
| 31.2   |   | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)  or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                  |
|   |   |                                                                                                                                                                                                                                                                   |
| 32.1   |   | Certifications pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                              |

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 
|   | PLC SYSTEMS INC. |
|--------|------------------|
|   |             |   |
| Date:  | May 13, 2005     | By: | /s/ James G. Thomasch |   |
|   |             | James G. Thomasch |
|   |             | Chief Financial Officer  (Principal Financial Officer and Chief  Accounting Officer) |
|        |                  |  |  |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit Number** | ** ** | **Description of Document**                                                                                                                                                                                                                                            |
|--------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **         | ** ** | ** **                                                                                                                                                                                                                                                             |
| 10.1               |       | Amendment dated March 15, 2005 to Terms of Employment between PLC  Medical Systems, Inc. and Dr. Robert I. Rudko, incorporated by reference to  the Registrant’s current report on Form 8-K filed with the Securities and  Exchange Commission on March 17, 2005. |
|               |       |                                                                                                                                                                                                                                                                   |
| 31.1               |       | Certification of Chief Executive Officer pursuant to Rule 13a-14(a)  or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                       |
|               |       |                                                                                                                                                                                                                                                                   |
| 31.2               |       | Certification of Chief Financial Officer pursuant to Rule 13a-14(a)  or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                       |
|               |       |                                                                                                                                                                                                                                                                   |
| 32.1               |       | Certifications pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                              |

 

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